Compliance March 23, 2016

Actuarial Equivalence Key in Benefits Calculation Case

A federal appellate court found that the benefit offset used by a defined benefit plan administrator was correct.
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The 7th U.S. Circuit Court of Appeals has found that a defined benefit plan administrator used a permissible, and correct, interpretation of the plan document to determine a retiree’s benefits.

Roger G. Cocker contested the benefits amount expressed to him by the Terminal Railroad Association of St. Louis Pension Plan for Nonschedule Employees, which included an offset of pension benefits he was receiving from another plan. Cocker had taken early retirement from Union Pacific in 2006. Had he waited until his normal retirement age to retire, he would have received $2,311.73 in monthly benefits, but since he chose to begin receiving his benefits in 2009, he received $1,022.94 per month.

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The appellate court noted that the two dollar figures are actuarially identical, in the sense that the present value of the two streams of money is the same because the smaller monthly benefit is received for 111 months longer than the larger one.

The Terminal plan document provides that the benefit payable under the plan shall be offset by the amount of retirement income payable under any other retirement benefit  plan to the extent that the benefit payable under the other plan is based on benefit service taken into account in determining benefits under the Terminal plan. The plan also provides that if “the benefit under such another plan is paid in a form other than the form of payment under this Plan, including without limitation a single lump sum cash payment made prior to retirement, the amount of such offset shall be the dollar amount per month of the benefit that would have been payable under such other plan in the form of a Single Life Annuity commencing on the Participant’s Normal Retirement Date.”

NEXT: Determining the benefit offset

Cocker argued that the benefit of the Terminal plan should have been offset by the actual payments he was receiving, but the Terminal plan began paying him benefits offset by the larger amount of $2,311.73.

The court noted that the Terminal plan administrator was right, with actuarial equivalence being key to its conclusion. The 7th Circuit concluded that the monthly offset required by Terminal’s plan is the amount payable under the prior employer’s plan. While $2,311.73 was the maximum amount payable to Cocker per month under the Union Pacific Plan, he lost nothing by choosing to receive only $1,022.94, because the expected value of a stream of monthly receipts of that amount was equal to the expected value of a stream of monthly receipts of $2,311.73 received for many fewer months.

The court concluded that deducting only $1,022.94 would have given Cocker a larger Terminal pension and made him better off than if he’d received his Union Pacific pension in larger monthly payments for a shorter period.

Cocker further argued that the Terminal plan administrator had a conflict of interest. But the court found that irrelevant, as it found not only that the plan administrator adopted a permissible interpretation of the plan document but also that the interpretation was correct.

The 7th Circuit reversed judgment of a district court with instructions to dismiss the suit with prejudice.

The appellate court’s opinion is here.

Investing March 23, 2016

Active Funds Can Outperform Passive Funds

“Industry-wide averages can be misleading, and may be doing investors a disservice by giving them the perception that all active funds cannot outperform passive funds, which is simply not true,” says Timothy Cohen at Fidelity.
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By using two simple, objective filters—mutual funds with lower fees from the five largest fund families by assets—the average actively managed U.S. large-cap equity fund outperformed its benchmark in 2015, after fees, by 0.70% (or 70 basis points), according to new research by Fidelity Investments.

The research report, “Some Active Funds Rise Above a Tough Year,” says this same subset of funds also outperformed their benchmarks by 0.18% per year from 1992 through 2015, while the average subset of passive index fund slightly trailed its benchmark by 0.04%. While 0.18% per year of outperformance may not seem like a lot, Fidelity says, this may translate to more money to spend, or a longer and more secure retirement.

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As a hypothetical illustration, suppose a retirement investor saves $5,000 per year in two different accounts, one with 0.18% of annual excess return and one with –0.04% of annual excess return (assuming returns are net of fees and a constant “benchmark” return of 7%). At the end of 40 years, the balance for the account with 0.18% of excess return would be more than $64,000 higher than the other account, essentially earning an additional 6% of cumulative return.

“We believe that market outperformance—through the compounding of returns—can help shareholders increase their ability to achieve their most important financial goals,” says Timothy Cohen, chief investment officer at Fidelity Investments. “Excess returns can be an important driver of wealth creation, and actively managed funds offer you the opportunity to outperform the market.”

NEXT: Long-term results

Although past performance is no guarantee of future results, these filters have been remarkably consistent in identifying sets of funds with above-average relative performance over time. For rolling three-year returns, the average actively managed fund selected by both filters beat the industry average a full 98% of the time from 1992 through 2015. In addition, a statistical test indicates one can be 99% certain that the historical long-term outperformance of the filtered average fund relative to the industry is significant.

Fidelity’s research also reveals that in the other largest equity fund categories (international large cap and U.S. small cap) active managers had a better record of outperforming their benchmarks, even without applying the two simple filters. Actively managed international large-cap funds outperformed their benchmarks by 0.85% per year and U.S. small-cap funds outperformed their benchmarks by 0.99% per year.

“Industry-wide averages can be misleading, and may be doing investors a disservice by giving them the perception that all active funds cannot outperform passive funds, which is simply not true,” says Cohen. “We believe the results of applying certain straightforward and objective filters can be a helpful starting point for investors seeking to identify above-average actively managed equity funds that beat their benchmarks.”

The report can be viewed here.

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